Incoming data continue to suggest that the economy is still growing at a modest pace: no recession, but also no blast-off like many had hoped by this time in the recovery (or well before). At the same time, it is becoming clearer that the Fed would like to begin the normalization process sooner rather than later as the unemployment rate has fallen to 5% and evidence of froth in some asset markets is starting to emerge. So what does this portend for the near- to intermediate-term economic outlook? It would seem that the best we might hope for is more of the same, while at worst the Fed's tightening, combined with economic weakness and geopolitical uncertainty outside the US, could ultimately push the domestic economy back into recession.
The good news is that there are things we can do to both reduce the impact of higher interest rates, as well as jumpstart economic growth. Specifically, we see four glaring opportunities, all of which will require a dramatic improvement in the political dysfunction that has characterized the past decade. First and most importantly, we must address the issue of entitlement spending through bold initiatives designed to ensure these programs' (primarily Social Security, Medicare & Medicaid) solvency for many years into the future. Second, we need to overhaul our corporate tax policies such that our companies are not at a competitive disadvantage compared to foreign companies. Third, we need to figure out a way to encourage the repatriation of corporate cash that is trapped overseas due to the tax implications of bringing it home. And finally, we must make some investments in infrastructure and education to ensure our competitiveness well into the future.
Before going further, I want to expand a bit on the first of the aforementioned opportunities: addressing the problem of entitlement spending. The Congressional Budget Office, which is a nonpartisan federal agency, provides 10-year budget projections for Congress and the public each year. During the course of the year the projections are updated a couple of times. In the chart below we show the latest projections for federal government debt, which were made public in August, 2015. It may not shock you to see the balances of gross debt and debt held by the public, which are represented by the bars, climbing unabated for the forecast period. Everyone knows that government spending has gotten out of control following the financial crisis and two protracted wars. What may come as more of surprise, though, is that the CBO projects that the ratio of gross federal debt to GDP, represented by the yellow line, will fall from the 2014 level of about 105% to about 98% in 2025. Is this even remotely possible given all we know about ballooning Medicare and Social Security payments in the future?
Simply put, the answer is no. The CBO's projections are highly unrealistic, and here's why. The chart below shows both historical and projected expenditures on mandatory items as a percentage of total federal government outlays. As you can see, the CBO expects that the total of Social Security, Medicare, Medicaid and interest on debt will increase to nearly 70% of total federal outlays compared to 56% in 2014 and just 22% in 1965. Remember, spending on defense and all other "discretionary" items is not included in these balances.
The next chart shows that according to the CBO, total "discretionary" outlays are expected to fall from 34% of total outlays in 2014 (and 66% in 1965) to just 23% of total outlays in 2025. Perhaps even more unrealistic, outlays on defense are projected to drop to 12% of total outlays by 2025, compared to an average of 21% from 1975 (roughly when Vietnam expenditures subsided) to 2014. Say what you want about our spending on defense, but does anyone really believe these projections reflect reality? After all, robust spending on national defense is one of the few areas on which Republicans and Democrats seem to agree.
The CBO does the country a disservice by making projections such as these. If the full extent of the budgetary problems are not well understood, how can we be in a position to address the problems? Addressing the long-term issue of entitlements is such a big issue because in doing so we could better afford to make some of the near-term investments in infrastructure, education, and corporate tax relief that should be viewed as imperative if we want to remain the leader on the world stage. As we go through the election campaign process next year, we'll be looking for the candidate most willing to give it straight to the American people.